At no point did I think the difference in inflows was anywhere close to 8.5x. And it does worry me.
I'm familiar with the contention that even having some active players in the market will arbitrage the prices back to fair value, but when they compose such a small share of such a large market that's no longer a trustworthy assumption to make.
There's no law that I know of that prevents active players from exploiting the knowledge that passive money will go wherever the market tells it to. There have got to be a lot of opportunities here for profiting, legally, at the expense of those passive investors, that goes beyond simple margin arbitrage.
My point is, the less active money there is around, the less accurate our concept of a correct value can be. This situation has the potential to de-stabilise the economy sooner rather than later.
Can you expand on what exactly that means?
If the majority of the market is passively rebalancing, does the true value matter or does the weighting swamp it?
I see how one would make money on arbitraging pre- and post-90s mandatory rebalancing by major passives. I'm less clear on how one arbitrages difference between the prices passives are investing at and a "true" price.
If the market is systematically over-pricing companies, you create a private company and then take it public to cash in on the inflated prices. If the market is systematically under-pricing companies, you buy up a company for less than it is worth, and then run it as a private company for profit-making purposes.
What does that mean?
Perhaps A is large caps, B is small caps, and C is metals, it don't really matter for the sake of discussion.
You started off with purchases equal to your 33% 33% 33% goal ratios but after a year of unequal growth you're overweight C and underweight A.
Active rebalancing is selling enough C and buying enough A to get roughly equal ratios of A:B:C.
Passive rebalancing is if you're contributing $5K IRA per year or whatever, dump all your contributions into underweight A. Or whichever is underweight at any time.
Basically if your position ratios don't match your goal ratios, if you're selling thats active rebalancing and if you're merely changing the ratio of what you buy because you're a net investor thats passive rebalancing.
Going back to the real estate analogy dumping money into purchasing a lot in a gentrifying neighborhood is an analogy for passive rebalancing. If you sold your best performing property to fund it, that analogy would be active rebalancing.
Depending on the weighting method of the index you're tracking (and other indices that include your stocks), the indices need to rebalance purely in response to "price changes happened and reallocation is needed."
This requires buying at minimum (or buying and selling as VLM pointed out). That buying moves the market when there's a significant amount of money in index following funds.
The initial comment was about reaping arbitrage when (I think) the price the index following funds made diverges from the actual (ex index involvement) price.
I was wondering how that's operationally relevant or whether the "Don't fight the Fed" rule comes in, given that there's a massive amount of money in index funds.
Someone with more knowledge would have to chime in as to the effect in aggregate of rebalancing playing against active moves (for fundamental reasons).
I think the relevant mispricing introduced by passive investing is the relative one. The question is not that passive investors are driving the S&P 500 index higher than it should. The thing is that they are failing to distinguish company A, which should ouperform because it's doing well, from company B, which should underperform because it's not doing so well.
Sure. But it's unclear where the equilibrium is between the volume of passive investing and the volume active investing (or if there is one).
In the meantime, the increasing share of passive investment is causing the prices on all these assets to become more correlated. This increases systemic risk. When everyone diversifies completely, you lose the benefits of diversification.
It's unclear to me how well investors recognize this shift in systemic risk. Obviously there will always still be some active investors. But how can you be sure that the economy won't be destabilized from this?
So the momentum of the idealogy has shifted from people trying to beat the market to people throwing up their hands and following heuristics. The larger the momentum of the heuristic the more robust it is. (Which is bad, in an antifragile vs robust sort of way)
To use a real world example, you could say that the overall restaurant industry is vibrant only because individuals naively underestimate the difficulty in starting one. The naive trying is what produces a competitive landscape that discovers 'quality'.
Similarly, the naive trying to get VC capital (despite the majority of ideas not having the scale/growth potential needed to fit the VC model) creates a vibrant technology and new-lifestyle scene.
So during a momentum re-stabilization phase, it's possible that the truck topples over the railing instead of back onto the road. Also, the overall reduction in number of individual of thinkers also increases the impact of bad-faith agents in positions of unfair leverage.
Retail investors don't act as a rational pricing mechanism. 99% of them don't discount future cash flows, examine balance sheets, or evaluate growth prospects. In fact they statistically buy high and sell low which only serves to make boom and bust cycles more severe. They are the greater fools in the Greater Fool Theory.
Turning "dumb" retail money into passive index fund flows can only serve to make markets more efficient and stable. That said, if I had to guess the massive flows to index funds will come to a grinding halt as soon as the next market correction.
While indexing has historically been the best strategy over the long run, the low interest rate environment has made it appear to be the best strategy even in the short term. This is not normal and is due to the high correlation still lingering after the effects of QE. Once interest rates rise enough to make alternatives more appealing this will balance itself out since investors chase returns.
Generally you should avoid putting money into stock markets with anything less than a 10 year window unless you love risk. And you should never put your emergency fund in the stock market since stock market crashes and needing said emergency fund tend to be highly correlated, which means when you pull your money out, you are all but guaranteed to be selling low.
I invest in their S&P 500 ETF because it's the cheapest way to get diversified exposure to the 500 largest American companies, and I believe that the 500 largest American companies will be more valuable in the future as a combination of valuation, scale, and cash flows to owners, than they are right now.
I think it's plausible that these managers exist, but they're impossible to identify ex ante. Furthermore, a smart manager will charge fees that are equal to the alpha they generate. So even if the EMH is false in some broad sense, individual investors should act as if it were true and simply invest in low-cost diversified funds.
In the next breath you say that even if the EMH is false "individuals investors should act as if it were true".
This makes your post somewhat ambiguous; not so clear about which position you're advocating. How "plausible" is it that these managers are "impossible to identify ex ante."? Why is it plausible? "Impossible" seems like a pretty strict standard (akin to strong EMH), why not just say instead that identifying such managers before they outperform is "practically impossible" or just "really, really, damn hard and something that you're deluding yourself about if you think you can do it."
Also (assuming it is your position), it's important to clarify that you don't disagree with the assertion that many people do identify market-beating managers before they outperform. Probably millions of people have done it; it happens every day. What they don't do (in my opinion) is use skill or knowledge to identify the outperforming managers. If they do identify an outperforming manager (of which there are always many) it happens because of chance or luck. (Just as, IMO, the outperformance itself of almost all outperforming managers is due to luck or chance, not skill.)
Yet we know that hiring for programmers is utterly hopelessly broken beyond all belief, industry wide.
Therefore its very unlikely that people of a similar cognitive and training level that utterly failed at hiring programmers could possibly select outperforming investment managers given that being an even more difficult job. No one in HR or management is going to be selecting outperforming investment managers.
Its possible that someone outside HR and management is better at selecting the best programmers. Certainly plenty of advice from outsiders is given to hire more of coincidentally highly politically correct demographic group A or group B. Or perhaps ivy college admissions officers magically know how to pick future great programmers (LOL). Professors and college advisors might put forth a weak argument in their own favor. Still, money seems to talk and greed means management and HR, however awful they are at selecting programmers, none the less are the best skilled at it, regardless how low that skill level is.
(And yes, I understand that you agree with the conclusion there. But I'm saying what's the point of the verbal gymnastics in the first place?)
I think this is the kernel of what Bogle was saying and Vanguard is now reaping the benefits of.
Old system: active traders beat the market, therefore they charge fees slightly less than the alpha they're supposed to generate
New system: customers are more aware that their active trader(s) may not be the winners, so the acceptable fee to pay the traders decreases to the product of the alpha AND the risk of not picking the right traders
Why would they? Unless they're so rare that there are only a few of them, one would expect the market to encourage "fair" pricing of active management--yet a key dogma of passive investing is that the market is generally efficient, but the market for actively managed mutual funds isn't!
It seems more plausible to me that (handwavy):
1. People can, in fact, beat the market, with lots of effort (e.g. very large college endowment funds, which outperform smaller ones, presumably by spending more on management and research)
2. The barriers to entry are typically high (because most investors won't trust their money with someone with an unproven track record)
3. Those high barriers to entry both allow the few established genuinely successful fund managers to charge higher fees than otherwise (to your point, eating up the alpha they generate) and ensure that "managing a fund" requires good sales skills and not just good management skills (see, lots of hedge funds)
Or, in short, lots of markets are inefficient--both the stock market and the market for managed funds. But because the stock market is much bigger than the fund market, it's probably _less_ efficient. Or so we hope.
This isn't how causation works.
> A disbeliever in EMH should look to identify these managers and pay them some fee, rather than simply investing in the index and trying to minimize fees.
It is as much work to identify good fund managers as it is to identify good company managers. You might as well save some money if you go this route and invest in a portfolio of companies directly.
> Furthermore, a smart manager will charge fees that are equal to the alpha they generate.
Warren Buffett seems quite smart, I mean he made it to rank #1 on the world's rich list and I think he's one of the few on the top #100 that did it by investing in other companies rather than just building his own. Judging from his 40 year performance data he's generated rather more alpha than any other manager. He charges fees that are very close to 0.00001% for being a partner with him.
That would seem to contradict your point.
Or maybe he just believes the market might stay irrational longer than he can stay solvent.
My concern is that if everyone is in the passive investing boat then we're no longer following the market, we're making the market, and it's a big departure from the philosophical under-pinnings behind the idea of passive investing.
(We started out letting active players make the market by placing good/bad bets and winning/losing. We got a market that was at least trying to find the right price and we did well due to the low expense ratios. Now that we're in the majority, I'm concerned that no-one is trying to find the right price anymore.)
tldr; I have mixed feelings about passive investing over the long term if we're no longer small fish in a big ocean.
EDIT - I highly recommend watching some of Robert Schiller's Financial Markets lectures on Yale Coursera about general investment theory. Bogle is saying good things, but he simplifies it in a way that I can see might sound disconcertingly incomplete. You're not wrong to ask these questions if you're conscientious and smart enough to want more in-depth answers.
Obviously, these are edge cases (we'll never be 100% passive), but there is some concern that there will be a lock-in effect for companies currently in the S&P... It will be harder to grow if you're not in it, and it'll be harder to fail if you are.
There's also no reason why passive indices have to reflect the total market weighted for market cap.
Links #2-3 are affiliated with my own company, so you should decided whether or not to believe me.
I'm intrigued by your suspicion ... but I can't put my finger on the exact manner that this might play out ... it's really hazy.
It seems to me that the effect of everyones money going into index funds would be that firms large enough to be in the index would have less and less pressure to issue dividends ... if there is a ready market of buyers of your stock based solely on your size then why bother ?
If money flows, by autopilot, into an asset class wouldn't we expect that asset class to return less and less as time goes on ?
Yes, there are some IPOs, but overall new business starts are still in decline, and large portions of financial markets seem both too systematically risk averse, and yet willing to follow other risks blindly.
The problem is deeper than that. Active shareholders actually give a shit about corporate governance. Collectively, they put honorable and competent people on the board of directors, and make sensible decisions when other issues are put to shareholder votes. Vanguard and other indexing funds could barely care. Their incentive to care is so small, we may as well call it nothing. Whereas the employees who control these voting blocks at Vanguard can easily make decisions that cause 10,000x more financial impact than their total compensation. And whenever someone is endowed with such power, human behavior throughout our existence has shown most people will be corrupted by it (e.g. see government employees).
> Still, these funds retain the power of voice, the ability to exert shareholder influence on management and governance-related proposals. But critics say passively invested funds, with their lower fees, lack the resources and often the will to monitor their large and diverse portfolios. The Economist calls them “lazy investors.”...
> My fellow researchers and I set out to test that claim. In our forthcoming research paper in The Journal of Financial Economics, we show that passive institutions do indeed positively shape firms’ governance policies. Our findings run contrary to the presumption that passive investors lack the willingness and ability to influence firms’ policy choices.
> The results of our analysis suggests that passive investors affect firm governance in several ways. For example, we found that an increase in passive ownership is associated with a statistically significant increase in the share of independent directors on firms’ boards. In addition, firms with higher passive investor ownership were more likely to remove firm takeover defenses (for example, so-called “poison pills” and limitations on shareholders calling special board meetings). They were also less likely to have the unequal voting rights of a dual-class share structure.
Also, I would counter that in a firm, the legal and immoral loopholes that would give one party greater wealth would do so
1) at the expense of other parties inside the firm and 2) run the risk of bad optics / PR to institutional investors who look out for things like this when evaluating a firm.
Lastly, the aggregate of these factors is baked into the return on investment of a stock. In other words, I suspect that might be happening in firms that are making alot of money and providing healthy returns for shareholders. Alot less so at firms that are struggling and not providing much growth.
For instance, at the 2016 Alphabet meeting, they voted for Alphabet shareholders having one vote per share and adoption of a majority vote for election of the board. Those are the very core corporate governance oddities that Alphabet is using to allow the founders and Eric Schmidt to have total control of the company and Vanguard voted their shares towards better governance.
Obviously, since Eric Schmidt and the founders have the majority of the votes, these didn't pass, but they voted the way you would have liked and against management.
Tell me what you think the result of this scenario might look like. A manager wants to conduct an LBO that grossly undervalues a stock. He couldn't get the votes from shareholders if they were paying attention, but instead he walks up to management at Blackrock, Vanguard and State Steet, and offers the people in charge of voting a very lucrative job at the new private company. How do you think they'll vote?
I think a better approach would be to pass through voting to the owners, but given that most shareholders don't know enough for their vote to be more than a random guess, that wouldn't much solve the problem, either. But at least the people who are affected by the decisions being made are the ones making the decisions.
I don't understand why that would be the case. Just charge a flat fee for the fund and distribute proportionally to the teams whose companies do best.
It sounds impossible to satisfy your desiderata with unsophisticated investors. They will have to delegate the task of assessing board decisions to someone.
While Vanguard may vote all their shareholder proxies, they almost always vote along with the recommendations of management - practically never holding management accountable.
Proof: Take a look at their actual voting record on the S&P 500 fund https://about.vanguard.com/vanguard-proxy-voting/supporting-...
It is a huge problem (and probably responsible for much of the lawlessness we can find on Wall Street), but the switch from active to passive investment shouldn't change a thing.
No big fund manager has enough skin on the game. That has been true for most of last century and all of the current one, and the expected results are visibly there.
I don't believe this. They bring in axemen to cut jobs for a bump in stock price. For one, why do they allow for huge severance packages even when they fail?
His job isn't to make and sell cell phones. His primary function is to make the C-suite accountable to shareholders. The C-suite's job is to make and sell cell phones.
Frankly, Boards function mostly on business metrics and people skills that are generic to any business.
He has a working knowledge of how governments operate, and as such knows the right person to call and the right procedure to follow to get stuff done. He probably also still knows a bunch of people whom could be useful to know if you're operating a huge multinational company.
If that happens, you end up with resources such as labor being wasted. The efficient usage of the available resources is of course a much better indicator for the quality of the economy than the rise of stock prices.
I can't see why this is any kind of danger. Companies end up subjectively with "too much capital" all of the time in this market without being part of a large index. Look at tesla.
The more risky effect is that all stocks in an index become more correlated with it over time, leading to larger jumps in single names around earnings seasons when real information is released to the public.
If these passive investment funds create a positive feedback loop for some stock prices - I don't know if that's the case - then this could be a pretty high risk.
On the other hand, I would intuitively expect them to have a dampening effect on the "pump and dump" schemes that created so many bubbles. So, in a way, they could even help stabilizing the markets?
That won't happen (probably).
The less accurate our concept of correct value is, the more competition it will draw as the margins increase.
Realistically, we can be probably something absurd like 80% passive funds and 20% active investors and be fine.
I think you underestimate the size of the active players in the market, especially considering leverage, which they generally are to the hilt.
Vanguard is not nearly as active is most mutual funds, but they are not entirely passive either.
Vanguard has lower costs because it employs fewer people to execute fewer trades. That's all I really care about.
Could that be mitigated by people not completely jumping on the passive bandwagon (e.g. by keeping say 5% in active funds)? Wouldn't all that you need is an active enough and large enough market to resist manipulation?
The outflow is mostly from active domestic equity mutual funds (average expense ratio: 1%-1.5%) to index domestic equity ETFs (average expense ratio: 0.1%-0.2%), so it's really about lower costs and the relative underperformance of active management.
Active managers go around with the notion that as they die off to be replaced by index funds, that there there will be no price-finding.
But here's the thing - before managers, and before mutual funds, most people were buy and hold investors. There was very little "price discovery" compared to today, as most stocks sat on a shelf (literally, as people had paper certificates for the shares they owned).
In that world, the price discovery function was quite small, but clearly adequate.
Today, there are many highly-paid managers who "actively" manage money. ( I challenge the "actively" portion, because many are closet-indexers. If you google "active-share", you can find more about this.) But even if they aren't closet indexers, in any given year, most cannot beat their benchmark. When they can't beat their benchmark (which, ironically is an index), they are inefficient.
That statement bears some emphasis - When Active managers cannot meet or beat their benchmarks, they are __REDUCING__ the market's efficiency. Put simply, they were wrong on what they thought the correct price should be, thereby hindering price discovery.
Read that last paragraph again - it's extremely important. Also, note that there are many people on Wall Street who are highly compensated, and afraid that their jobs will go away because of indexing (note that the S&P 500 is only one index - there are hundreds of others, including MSCI and Russell indexes). They are right to be concerned. After all, as in anything in life, if you can't keep up with the benchmark, you will get cut. This happens in professional sports, people in college with poor grades, and anybody in a sales job. And it's been happening in finance since before any of us were born.
One final note: Back in 2001, the US markets moved from fraction pricing to decimalization. In short, the price increments went from 1/16 of a dollar to 1/100 of a dollar (i.e. a penny). That's a six-fold improvement in pricing accuracy. To think that having less active money will destabilize our economy is unfounded.
If I recall correctly (and again, it's been a while), I think the amount of passive funds has to be quite substantial for markets to be really bad at reflecting value over the long run.
If investing decisions get slower in general, then I think it would be a good thing. The number of company decisions made only for only the next quarter rather than long term profitability would be much less if it took time for people to switch the companies they invest in rather than doing so instantly, which would in turn make a more efficient and stable market.
As more shares of a company are held by passive investors, the fewer are available to trade on a daily basis, right?
Index funds are so successful because managed stock funds, as a class, underperform the market indices. So do hedge funds, which are a net lose for their investors. People are finally aware that Wall Street's stock pickers mostly aren't very good.
Any active trader remaining in the market. Fortunately, active traders still make up a large part of the market. And the bigger indices grow, the larger the opportunities for active traders to profit. It's not a real problem — it's self-correcting.
I appreciate that finally someone puts forward a rational argument as to why index fonds will keep working. Books and online resources tend to not take a critical look at the system at all or they offer an answer along the lines of "Trust me!"
Having said that, only hindsight is 20/20! It feels like we are rushing into the next great financial experiment. In a complex world there is simply no telling what's actually going to happen. I assume (any sources?) that currently more money than ever is flowing into index fonds. Furthermore, chances are this is just the beginning. For instance, the buy-and-hold hype is just arriving in Europe. Blogs and online communites on this topic are currently mushrooming here! Yesterday I even saw an ad on Germany's biggest TV station right before the evening news. This is very unusual to say the least as the common people of Germany by and large have an incredible amount of distrust in anything but savings books! This current gold rush mood is just scary to me as usually, when something hits mainstream media, the magic is gone!
Anyhow, the question I am asking myself is: What will the market do now that it has access to more cash than ever? Are the markets even productive enough to put those sums of money to good use? Or is this bonanza just FU-money that encourages more reckless behavior?
I can only speculate as to what is going to happen but my hunch is that in the long term the gap between returns from index fonds and savings books is going to become a great deal smaller as more people are willing to shoulder risk for companies and thus risk premiums go down. There may still be active traders who try to find opportunities but I suspect structurally the percentage of passive investors will expand quickly and won't go back below today's percentage.
Money is cheap at the moment because growth is low, and that in turn means risk premia are lower and so on, but I don't think that's related to the rise of index funds. Then again I never understood why active management was so popular in the first place.
Yeah, the question seems to be about fresh money. You could be right that we are mostly witnessing a shift from actively managed funds to indexing. As far as my home country (Germany) is concerned indexing seems to become more attractive to people who never invested, though. Now that I think about it I am not sure whether or not this kind of money would be "fresh money" as these people stored their money in banks who were probably investing it.
> Money is cheap at the moment because growth is low, and that in turn means resk premia are lower and so on, but I don't think that's related to the rise of index funds. Then again I never understood why active management was so popular in the first place.
As I understand it, risk premia is not related to growth. It is simply the costs to transfer risk to someone else. Active management was probably high in the past as banks had little incentive to sell passive investment plans: If people don't constantly buy and sell they don't cause transaction costs and thus income for the bank. Active and passive management are both neither inherently wrong or right. Until now active investment has been irrational but it could theoretically change if the share of money passively invested is high enough, say (made up number incoming) 80%.
My point was that investors targeting a particular rate of return are having to take on more risk (because growth is low), which in turn lowers the risk premium through ordinary supply and demand.
Maybe. Money is cheap if you are a bank or a government backed borrower (like a conforming mortgage loan in the US).
If you have collateral, like the car you're borrowing against, money is kind of cheap ... also if you have a perfect credit history.
But I am not so sure that money is cheap right now out in the real world. If you are a new business with no track record or a consumer with poor credit history I think money might be quite expensive for you ...
Really? My understanding was that (non-mortgage) subprime lending was higher than ever, business loans were cheaper than ever...
Doesn't that suggest people on average have had a misplaced fear of stock (indices) in the past, and that capital is now more efficiently allocated? Sounds like it would make the world better off.
Yes, I think this bit is pretty much agreed upon today. Hence the run for indices.
> and that capital is now more efficiently allocated?
That sounds likely to me.
> Sounds like it would make the world better off.
As tempting as it is to argue one way or another ... I think that's an impossible statement to make.
But like I initially said, it's all just speculation anyhow. Tbh these kind of discussions are inherently whacky. Chances are everything you've quoted from me is flawed on so many levels if one takes a closer look.
Discussing finance is mostly a fool's errand.
I'm having trouble understanding why this is the case. Care to clarify?
That being said, consider what would happen if stock prices did start to vary randomly - if you had actual research suggesting the price was too high or too low, you could trade accordingly. This would net you a profit, and also help push the price in the opposite direction, towards whatever a reasonable price is.
The larger the deviation from the "correct" price, the larger the potential profits are to be had. So if the problem ever starts to be significant (i.e. a few cents of deviation caused by index funds), this means a very large potential profit for any active funds or traders out there. And so we would expect the system to reach an equilibrium - where there are just enough active funds and traders to snatch up the profits that arise from tiny price errors and distortions caused by index funds. In effect, the index funds are paying those remaining active funds and traders a tiny "management fee" (in the form of exploitable trading behavior) to figure out the appropriate price of stocks for them!
Imagine that 99.98% of all investors are index funds, and there is a company BigCo that is at some point is at the top of the market. So pretty much every index fund invests in it.
Then suppose BigCo makes some move that would traditionally be a mistake. Like it has some scandal, the sales drop off, etc. Say it even has a bad quarter.
How do I, an active investor (among the remaining 0.02%), make profit from the arbitrage? For the stock price of the company to fall, there'd have to be no buyers at the given price. But the index funds will keep investing in it. Why would it drop off even a little?
This would require a long-term view similar to how Berkshire Hathaway is acquiring businesses. If active investors' short-term price speculation were reduced in favor of long-term bets, that might be a good thing for businesses and the economy overall.
And of course, if this situation actually becomes commonplace, chances are the market for index funds is going to self-correct since a well-performing stock needs either solid dividends or above-average growth. A market with 100% indexing can not give you above-average growth, and dividends depend on actual business performance.
Good stock pickers > Index Funds (blind money) > Bad stock pickers
By investing on index funds you are betting in the average of the average (a fund is already an average of undervaluated and overvaluated stocks).
However, by investing on managed funds your probability of having profits over index funds is low: even if stock pickers that beat the market (by definition) amount to 50%, extra fees make most of them still less profitable to investors than passive funds.
You can only tell them after the fact
The implication of the random walk theory is that current information is already uilt into the price of the stock. That is only true insofar as there are active traders acting on that information. The parent is merely explaining why those traders will exist, and why you only need a small part of the market to actively trade.
We'll see how the next large correction plays out. That the "problem" may be "self-correcting" is not very reassuring (the dot-com bubble and the subprime fantasy also ended with some nice self-correction).
I'm not 100% sure I understand the argument or have presented it correctly. It's reassuring.
The other takeaway here is that if you have a theory that ETFs are going to become increasingly popular, you could "test" that theory by investing directly in companies with run ETFs.
For example you could buy some NYSE:STT or NYST:BLK and that might help you invest in "people pay a premium for the liquidity and other benefits of ETFs". Of course, you'd want to believe that that theory will outperform the S&P 500 :)
My thinking goes like this - as less money in invested actively, the market becomes less efficient at pricing. As the market becomes less efficient at pricing, it becomes easier to make money as an active trader. As it becomes easier to make money as an active trader, more money is invested actively, and the market becomes more efficient at pricing.
I may be using "active trading" incorrectly -- I just mean any kind of non-passive trading, both long and short term. But presumably, any kind of active trading theoretically increases the pricing efficiency of the market?
It only stops being like this if pricing gets so poor that active funds can start to trade in ways that the passive funds can't replicate, either because they're faster or more frequent or have some other trading advantage that makes it very hard for the passive fund to replicate it effectively.
Wouldn't it be that the market becomes as efficient at pricing as the accuracy of index inclusion ?
That is, we have replaced the widely varying performance and heuristics of active stock pickers with the more formulaic S&P 500 pickers ?
Presumably that's a lot more efficient, but I suspect there is room for errors and games in index inclusion ...
Here's an excerpt from a long and boring story:
... One day, I couldn't log in to their website. Attempting to go through "forgot my password" had me fill out a long form with security question. I filled it out, pressed submit, and was presented with the same form, but blank. No error message, nothing else. I thought their website must be broken that day, tried again the next day with the same result. After doing this a few times, I called them. Turns out, my account got into some invalid state. It took them more than a week after that to figure out what was wrong with the account and fix it.
Then, my account fixed, I tired to buy some eft-s. Website replies: "Cannot perform this transaction, call us for assistance". I think that's a temporary outage, try again the next day. I called them again, waited a while to get an agent, found out they needed some more documents from me. I sent them in, but there was no way to find out if they were happy with the documents on their website ...
Big finance seems particularly bad at user-facing technology. Which doesn't really give me confidence in their back end tech.
> If I have to call them twice....I'm looking to get out of the shitty relationship I find myself in with that company. [emphasis mine]
You are way too sensitive and demanding, IMHO. You're probably a developer: is this how you want people thinking of you when you inevitably push a bug? I can understand looking elsewhere after a pattern of problems and repeated frustration with no improvement, but getting pissed off just because you have to talk to someone one or two times is just unreasonable. Have a little empathy for the people on the other side.
It is because I have empathy for the person on the other side that I'm angry at the corporation for making me have a conversation I really don't want to have. I am always nice to the person I speak to, despite being angry at the company they work for for wasting my time and making me interact with them in a way I really don't want to.
My anger is over the fact that I've been given no option but a phone call.
I disagree with that pretty strongly. The phone is the second-best method for communicating a complex or unusual problem, only behind a face-to-face meeting.
Anyway, the worst customer service experience in common use is actually the fixed-option support menu (that usually obscures how to contact a real person).
The real determiner of good customer service is how the process was designed and how empowered the representatives are to fix your problem. Case in point: Amazon's famous customer service. I had an unusual problem with an order recently. Their chat support utterly failed to help me after several tries, leaving me very frustrated. Their email support couldn't help me either, but explained I needed to call. It turns out only their phone support is empowered to escalate things to someone who could help, plus the it was much easier to relate my issue to them. None of that frustration had anything to do with the phone vs. chat vs. email, but everything to do with Amazon's (poor) support choices.
> My anger is over the fact that I've been given no option but a phone call.
I can understand feeling frustration at that, but not anger.
Plus Schwab and Fidelity both offer better additional products. Both offer totally free, no catches, ATM reimbursement, no minimum balances, no fees alternatives to a checking account. Fidelity also offers a no annual fee 2% cash back on everything credit card.
Vanguard has a different cooperate structure, however, if that's important to you.
This is obviously a Fidelity marketing spiel...but it's not a lie...Fidelity's active funds (which they made their name on) are definitely more expensive than Vanguard, but if you buy their passive index funds, you basically get equivalent expense ratios. (Same is true at Schwab.) And IMO, their website is far better than Vanguard's. I'll give Vanguard credit for jump starting passive investing for the little guy, but they aren't significantly different than their competition anymore.
>The $96.4 billion Fidelity 500 Index Fund (FUSEX), which tracks the S&P 500 Index, will drop its annual expense ratio by 0.5 basis point. The gross fee is now 0.10%, with a current net fee of 0.095% due to fee waivers. That will fall to 0.09% on July 1. In comparison, $45 billion Vanguard 500 Index Fund (VFINX) has an expense ratio of 0.16%
Fidelity also offer iShares ETFs (also low expense funds) as well as their own low expense ETFs commission free.
I can't comment on Schwab because I don't use them but from what I hear they have very similar offerings for low cost mutual funds and ETFs.
There was also just a commission price war a month or so ago initiated by Fidelity and as a result most brokerages dropped their commission significantly.
From what I understand Vanguard offers more services if you have a profolio over $1 million.
I'm very happy with Fidelity. I only purchase low cost index ETFs through them. You're going to pay more if you want active managed funds, but that's not the topic of discussion.
Even if you don't use their brokerage services you should use either Fidelity or Schwab's checking account. Really, a no brainer, banks don't offer anything even close to as good.
It's very competitive market nowadays and as another commenter pointed out, Fidelity has a much better website.
EDIT: What I meant by "their brokerage accounts are all very, very similar" I really mean "their brokerage account offerings are all very, very similar in price for someone interested in investing in low expense ratio index funds."
That said, we probably agree that it's a market without a lot of competitive pressure, and that often results in poor customer service (just as in the case of telcos).
It probably depends on what stage the company is in. My employer relatively recently went public, but we only have one choice of provider.
Although negativity on HN is often too high I am glad it is here when it comes to articles like this one!
So a disclosure that they use a massively popular product is now an advertisement?
Just one time I'd like to open the comments and not have someone saying "fake news" or "this is just an ad" or "stick with the facts".
Vanguard is an interesting company doing big things. They invented the index fund. They are massive. The New York Times profiles companies like this often.
Personally I find this more interesting than a Musk tweet announcing an announcement six months in advance.
No it isn't. I merely said that the article reads like an advert (not: it is an advert) and furthermore I said the affiliation would not help to shake this impression off. This is merely an aside and still doesn't imply it is an ad. My main problem with this article is that it is not critically examining what it is reporting about. Whether or not it actually is an ad is secondary.
I don't think this is likely, but I think it's clearly possible, and noting this potential conflict of interest seems prudent. This is what the disclosure is for.
I never said they would. I could imagine they got paid for this article but if I said so I would go out on a limb as I don't know whether that's the case.
All I am really saying is this:
> What I miss is a critical examination of the situation.
I think this is a more balanced article on Vanguard:
(It's from December 2016, though)
Newsreaders are not journalists, and being unable to form an opinion of their own, they are often willing to regurgitate anything their sources tell them without fail.
In my opinion the Reuters/AP feeds and The Economist do a good job of providing enough info you can make up your own mind based on your own preconceived biases, though.
"Journalists" are not journalists, and being unable to form an opinion of their own, they are often willing to regurgitate anything their sources tell them without fail.
The basic value proposition seems to be that Wall Street is extracting more value in fees than they're making in smart stock picks. Which thus far has been pretty accurate, but is the contribution of stock pickers actually zero? Is it negative? Where do we reach a fixpoint, and how? Do the stock pickers, clever scamps that they are, figure out a way to take advantage of the Bogleheads and their naivete? Are they already doing so? Is this going to turn the stock market into just one big house of cards?
I mean, don't get me wrong, I absolutely buy that Wall Street is a bunch of crooks-- it's a hell of a lot easier to extract fees from your customers than it is to beat a market full of highly motivated Ivy Leauge MBAs. But where does it stop? If I've seen any trends in the financial markets, it's that every good idea will eventually be flogged to death, usually with catastrophic results.
Interestingly (for me, anyway) the very large places I've worked at often let the peons listen to the analysts meetings over the phone system. Again, I was shocked by the complete lack of knowledge that analysts at big investment houses have in the companies they were analysing. They would be completely unaware of large acquisitions, law suits and any number of things that even the casual observer would know about. I really got the impression that their job was literally to attend the meeting and report the company's projections. The company's could get away with murder because nobody was paying attention to what they were doing.
Not sure if things have tightened up since that time in my life. I haven't worked for a big company since the early 2000's, but somehow I get the impression that there are probably plenty of ways to ride on the coattails of less than scrupulous executive compensation.
Few of the other analysts had an industry background in the companies they covered. Mostly they had an accounting/commerce/economics background. They were good at pulling together financial models from the data and information provided to them in briefings, but they largely missed the implications that even someone with a year or two of industry experience would understand.
I am reminded of the story of Max Planck and the chauffeur and the two types of knowledge .
Net of fees, probably. There's a certain amount of value contributed to the real economy by accurate stock prices, and a certain amount of that is created by reading the news, being aware of industry trends, etc. But the number of people needed to do that efficiently gets smaller all the time.
> Do the stock pickers, clever scamps that they are, figure out a way to take advantage of the Bogleheads and their naivete? Are they already doing so? Is this going to turn the stock market into just one big house of cards?
It's smoother than that. The more people are indexing, the more profitable the various types of active investment become. There's an equilibrium to be reached. We're probably in for higher volativity than present, sure - but the present low volatility is a historical aberration.
> If I've seen any trends in the financial markets, it's that every good idea will eventually be flogged to death, usually with catastrophic results.
More like it will get flogged until there's no more money in it and it's just a boring utility, like has happened to HFT.
Dunno. Maybe the wealthy have access to wonderful investments we don't; I certainly wouldn't know.
Is there a doomsday scenario, haha?
When the next (inevitable) correction happens, the tide will change and stock pickers will return to the spotlight.
(It might be not rational, of course. But markets are never rational. They are efficient — efficient in projection of our hopes and fears).
Passively managed money has been increasing because there are more low-cost funds available, and lots of education about stock picking versus passively managed funds (e.g. Warren Buffet, A Random Walk).
My theory predicts that when the next major recession happens, Vanguard and other passively managed funds will become dramatically less popular (which will amplify the fall), and actively managed funds will come back.
Your theory predicts that none of this will happen when recession strikes.
So, I propose we wait and see. :)
Picking stocks vs Picking managers vs Passively investing, but sure. You're right in principle but i'd question whether it's true in practice?
In an economic crises, will everyone try to sell the same set of funds and will crash the funds themselves?
Here's one: 
"Second: One of my little stock-market obsessions is that index funds free-ride on the work done by active investors. Someone needs to make decisions that allocate capital to businesses. A world in which everyone indexes, and in which no one thinks that active managers should be able to charge for their services, is a world that will spend too little time and effort on allocating capital to the right businesses. That's not the world we live in: A lot of people still actively work to allocate capital..."
For one, the stock price of a company has no direct bearing on its capital. Only at IPO time or when a company is raising additional capital is the stock price relevant for the capital. E.g. Google's stock price has increased 15x since their IPO, but that has had no effect on their capital. Any other time besides the IPO and when raising additional capital, it is just money changing hands between stockholders, the company doesn't see any of that. Of course, the initial investors often only invest in the capital with the understanding that they will be able to easily sell their shares later. And there are some secondary concerns: employees might have stock or stock options, stockholders can influence the board and hence management, and too low a stock price might engender a hostile take-over.
Secondly, the market is frequently very wrong about pricing stocks. It was happily 'allocating capital' to internet stocks during the dot-com bubble, to financial stocks up to 2008,... A metaphor created by Benjamin Graham, and often repeated by Warren Buffett, is that of Mr. Market : a manic-depressive fellow who has periods when he pays way too much for stocks at certain points and sells stocks at way too low prices at others.
That said, it mostly works. To a company it doesn't really matter all that much that the stock market undervalues your stock by 20-30% or more at some times (a good opportunity for share buybacks!), and overvalues it at other times (a good time to raise additional capital, or use your stock for takeover bids of undervalued companies). Of course, companies often do exactly the opposite: share buybacks when their stock is overvalued and takeovers overvalued companies when their own stock is undervalued...
But all the capital decisions are in the context of the stock price. If an outside group looks at investing, that will be in terms of current shares; if the company gets bought by another or does a merger, that transaction will be determined by the current share price.
> Secondly, the market is frequently very wrong about pricing stocks. It was happily 'allocating capital' to internet stocks during the dot-com bubble, to financial stocks up to 2008
Some of those internet stocks were worth far more than even their inflated valuations at the time (of course, many were worthless). The market price is always going to be a best-guess consensus estimate, sure, but a lot of these things are just inherently hard to figure out how much they're actually worth.
A tangentially related point is that membership in e.g. the S&P500 imparts a big financial advantage to companies for a somewhat arbitrary reason, due to passive investing.
An ETF or Fund like vanguard is a company that issues "coupons" and then buys and sells them (and various related administrative things, e.g. forwarding dividends while combining them).
So when you buy an ETF "share", what happens is that you buy a newly issued coupon from this company. This company gets notified, and as a result will put in market orders for these shares (while combining them in smart ways), and once it has bought the shares, issue the "share". (needless to say there's aggregation happening)
When you sell the reverse happens. You essentially request the company destroy the coupon. In response the company will sell shares. Once the shares are sold, the company will transfer that money (ie. whatever they got) to you.
So to answer your questions, in a flash crash scenario as an ETF owner you'll experience more lag in both cases. Ie. whether you're buying or selling the lag will add to your disadvantage compared to the rest of the market. So simplifying things, if a flash crash happens and you own an ETF or a fund you'll only be "allowed" to sell once the drop is over. If you try to buy at the bottom your order won't be filled for a while. Mind you this will be in the seconds range, or in particularly bad cases a few minutes.
In the US, there is also regulation that allows funds to pause redemptions. So if you own a fund that fears it may be significantly affected by a market drop, it can then block your money (regardless of what a contract you have with them says) for a period of up to months. Given what has historically happened, for small funds this means if there is a large drop, they will block your money making things worse (but somewhat avoiding feedback in the market that would cause individual share crashes). You will lose something like 20-80% of your capital if this happens. The smaller a fund the more likely this is to happen.
So an ETF should only be used for amounts of money that are truly too small to buy individual shares, something under maybe $10k. For everything else you should put in the work to buy the individual shares. If you don't do this, yes there are costs that will be imposed upon you in adverse scenarios.
have a read about the ETF redemption mechanism: it is almost the exact opposite to the way mutual funds work (which is what you have described)
their behaviour at times of stress is correspondingly different to that of a mutual fund
When you buy an ETF, you don't buy a newly issued cupon. You buy it from another market participant on an exchange - hence Exchange traded fund. What you're describing is closer to classic mutual fund. Each ETF will have "Authorized Participants" who make sure that the ETF mirrors the underlying assets.
So the market depth for any ETF should be constant, regardless of the value of the underlying assets (assuming non-extreme values and outside of crashes or rapid movements).
And yes, to be more exact, the market depth for an ETF should be a function of the amount of trading occuring in that ETF, not so much a constant. In any reasonable timeframe it should be constant.
>> So to answer your questions, in a flash crash scenario as an ETF owner you'll experience more lag in both cases
So the lag is due to inability to quickly buy/sell the percentages that were allocated for different stocks to build a share, right?
And if I understand correctly, this means if people keep their emergency funds in ETFs, in a crisis, they probably won't be able to access those funds quickly enough to get it at list price (because the price will move because of the lag).
Consider a ETF that consists of a single stock. IF the stock drops, the AP will lower its Bid/offer spread, and force the ETF down to the same level as the stock. But as this is a reaction to the stock falling, there is going to be a lag between the stock falling, and the ETF falling. This doesn't mean that you can sell the ETF at a higher price, necessarily.
(A similar already occurs with huge institutional investors (e.g. retirement fund managers) that have too much money to invest to worry about small caps - Warren Bufett also has this first-world problem. Yet another similar effect occurs through bigger caps getting more publicity, so more people invest in them, disproportionately driving up the price.)
The result is smaller caps become more attractive (to small investors). Which results in greater investment in them - but only up to the point allowed by the above effects. So the undervaluing persists.
Kinda similar to tiny startups finding tiny markets attractive, that aren't worth it for incumbent to pursue.
The ETF is backed by stocks in other companies, so if one person tries to sell someone else should be willing to buy, so long as the sale price * the number of shares is below the collective value of all of the shares held by the ETF.
Collective ownership of companies is a more interesting question. If everyone owns fractions of every company, what are the incentives for good governance at any one company? If it goes bankrupt, it's only a tiny fraction of everyone's portfolio.
Matt Levine has covered the latter beat for quite some time.
And all the other companies in the same market segment will then gain a share of the customers and income of the now bankrupt company, so there is little to no effect overall.
Of course this is exactly why some people choose to invest in markets instead of individual companies, because that has less risk.
Of course this is also why other people choose to invest in companies they assessed are way ahead of their market, because that is more profitable.
I feel like the increase in stock prices in the recent years is caused by this demand, not by an increase in productivity. The sinking ROI of dividend-driven stocks is an indicator for that.
Given the amount of money just looking for a home the market has no where else to go but up until that money stops.
So even if my investments were in the black in the macro scale, with tax loss harvesting I can realize additional gains from the inevitable dips that happen on the more micro scale.
Once you tax loss harvest once, you lower your cost basis on the investment to less than you originally paid. You can only subsequently tax loss harvest on the same security to the extent that the value of the investment is lower than your new lower cost basis. This will become harder as time goes on and you have previously tax loss harvested many securities.
Their white papers all use a timeframe of 10 years to show that Wealthfront is cost effective. I'm pretty sure they don't want customers thinking through all the implications of longer investment time horizons.
If you're presupposing the assets are similar, this is unlikely to happen to any significant degree.
The standard way to increase your odds of being able to tax loss harvest is to own as many different uncorrelated securities as possible. You can take this to mean a fund per industry (as Betterment and Wealthfront do) or even to the extreme of only owning individual companies. That way, some are up and some are down, and you can TLH. The more slices you divide your portfolio up into, the longer you'll be able to do it. But I think realistically (especially factoring in inflation), this strategy will stop giving results before 15 years.
(Make sure to turn off inflation-adjusted)
I think you'll see that in the last 90 years, even the worst market crashes don't take the index down to a level lower than what it was 15 years prior. To put it another way, pick any time in the past 90 years, the S&P 500 is always higher 15 years later than that date and every day afterwards. Maybe slicing up your investments into finer-grained categories than the entire S&P 500 will help ... but I'm very skeptical that anyone can TLH for long periods successfully.
If you want to pay a perpetual 25 basis points per year for Wealthfront or Betterment, go ahead, but it seems unlikely to me you'll come out ahead of a simple index fund if you are investing long term.
Like I said though, I have seen very significant returns from my loss harvesting. Even without a yearly source of capital gains, it definitely does not hurt to collect the losses and use them later in life (for instance if you sell an investment property).
No. If you own the assets directly, and they are traded on the exchange (like the ETFs WF/Betterment use) they can be transferred around without triggering a sale event. Target date funds and the like would probably have to be sold.
I have my tax advantage at VG and my taxable has been all over the place finally settling with CS for now.
Although Betterment offers fractional shares, which is confusing, not sure if they're actually ETNs representing fractional ownership of ETFs. I don't know how that works legally.
With regular brokerages you can move stocks/funds around with a transfer.
"What is Tax Loss Harvesting? Tax loss harvesting is the practice of selling a security that has experienced a loss."
i.e. cycle long term gains after one year of ownership so that they are more likely to produce harvestable losses in the next year. Obviously this prevents the basis gains of TLH, but wouldn't it be dwarfed for users whose long-term capital gains tax rate is much lower than their short-term capital gains rate?
Even in taxable accounts TLH is really oversold. It's another way to shift taxes around, which can be good, but the obvious methods of maxing out tax advantaged accounts should be done first.
Also, Vanguard can easily implement TLH.
FT says it is about $2T net in the past 8 years, and about a third of volume today.
Also an interesting article because it talks about the potential issues on market volatility ETF inflows introduce
What happens when millions of people sell off their shares in say, VASGX (basically an 80/20 stock/bond index fund)?
Would that effectively tank the entire market rather than sectors doing poorly.
If indexing also implies passive/"set and forget"-style trading then you would actually dampen market swings. You'd have fewer people selling as the market tanked and fewer people buying the big rallies.
Right now things are great as there is a lot of hot money flowing. If people hide the money then you'd need something like stimulus to jump start the system again.